© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 21 Chapter PART V THE GOODS AND MONEY MARKETS Aggregate Expenditure and Equilibrium Output

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 38 Chapter Outline 21 Aggregate Expenditure and Equilibrium Output PART III THE GOODS AND MONEY MARKETS Aggregate Output and Aggregate Income (Y) Income, Consumption, and Saving (Y, C, and S) Explaining Spending Behavior Planned Investment (I) Planned Aggregate Expenditure (AE) Equilibrium Aggregate Output (Income) The Saving/Investment Approach to Equilibrium Adjustment to Equilibrium The Multiplier The Multiplier Equation The Size of the Multiplier in the Real World The Multiplier in Action: Recovering from the Great Depression Appendix: Deriving the Multiplier Algebraically

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 38 AGGREGATE EXPENDITURE AND EQUILIBRIUM OUTPUT The level of GDP, the overall price level, and the level of employment - three chief concerns of macroeconomists - are influenced by events in three broadly defined “markets”: Goods-and-services markets ■ Goods-and-services markets ■ Financial (money) markets Labor markets ■ Labor markets

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 38 AGGREGATE EXPENDITURE AND EQUILIBRIUM OUTPUT FIGURE 8.1The Core of Macroeconomic Theory

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) total quantity aggregate output The total quantity of goods and services produced (or supplied) in an economy in a given period. aggregate income The total income received by all factors of production in a given period. In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income). aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Think in Real Terms When we talk about output (Y), we mean real output, not nominal output. The main point is to think of Y as being in real terms— the quantities of goods and services produced, not the money circulating in the economy.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.2Saving ≡ Aggregate Income − Consumption INCOME, CONSUMPTION, AND SAVING (Y, C, AND S)

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) saving (S) The part of its income that a household does not consume in a given period. Distinguished from savings, which is the current stock of accumulated saving. Saving ≡ income − consumption S ≡ Y − C identity Something that is always true.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) EXPLAINING SPENDING BEHAVIOR Household Consumption and Saving Some determinants of aggregate consumption include: 1.Household income 2.Household wealth 3.Interest rates 4.Households’ expectations about the future The higher your income is, the higher your consumption is likely to be. People with more income tend to consume more than people with less income. consumption function The relationship between consumption and income.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.3A Consumption Function for a Household

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.4An Aggregate Consumption Function

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Because the aggregate consumption function is a straight line, we can write the following equation to describe it: C = a + bY marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Because the MPC and the MPS are important concepts, it may help to review their definitions. marginal propensity to save (MPS) That fraction of a change in income that is saved. MPC + MPS ≡ 1 The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving).

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.5An Aggregate Consumption Function Derived from the Equation C = Y Numerical Example AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) ,000850

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.6Deriving a Saving Function from a Consumption Function Y- C=S AGGREGATE INCOME (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) ,

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Where the consumption function is above the 45° line, consumption exceeds income, and saving is negative.Where the consumption function is above the 45° line, consumption exceeds income, and saving is negative. Where the consumption function crosses the 45° line, consumption is equal to income, and saving is zero.Where the consumption function crosses the 45° line, consumption is equal to income, and saving is zero. Where the consumption function is below the 45° line, consumption is less than income, and saving is positive.Where the consumption function is below the 45° line, consumption is less than income, and saving is positive. The consumption function and the saving function are mirror images of one another. No information appears in one that does not also appear in the other. These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody(shape) aggregate household behavior. Note that the slope of the saving function is ΔS/ΔY, which is equal to the marginal propensity to save (MPS).

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) PLANNED INVESTMENT (I) What is Investment? capital stock investment Purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Actual versus Planned Investment change in inventory Production minus sales. One component of investment—inventory change—is partly determined by how much households decide to buy, which is not under the complete control of firms. If households do not buy as much as firms expect them to, inventories will be higher than expected, and firms will have made an inventory investment that they did not plan to make.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) desired, or planned, investment Those additions to capital stock and inventory that are planned by firms. actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) FIGURE 8.7The Planned Investment Function

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 38 AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) PLANNED AGGREGATE EXPENDITURE (AE) planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE ≡ C + I.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) Equilibrium occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output. aggregate output ≡ Y planned aggregate expenditure ≡ AE ≡ C + I equilibrium: Y = AE, or Y = C + I

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) Y > C + I aggregate output > planned aggregate expenditure inventory investment is greater than planned actual investment is greater than planned investment C + I > Y planned aggregate expenditure > aggregate output inventory investment is smaller than planned actual investment is less than planned investment Equilibrium in the goods market is achieved only when aggregate output (Y) and planned aggregate expenditure (C + I) are equal, or when actual and planned investment are equal.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 Are Based on the Equation C = Y. (1)(2)(3)(4)(5)(6) AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT (I) PLANNED AGGREGATE EXPENDITURE (AE) C + I UNPLANNED INVENTORY CHANGE Y  (C + I) EQUILIBRIUM? (Y = AE?)  100 No  75 No  25 No Yes No No 1, No

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) FIGURE 8.8Equilibrium Aggregate Output

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) Because aggregate income must either be saved or spent, by definition, Y ≡ C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium. By substituting C + S for Y in the equilibrium condition, we can write: C + S = C + I Because we can subtract C from both sides of this equation, we are left with: S = I Thus, only when planned investment equals saving will there be equilibrium. THE SAVING/INVESTMENT APPROACH TO EQUILIBRIUM

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) FIGURE 8.9Planned Aggregate Expenditure and Aggregate Output (Income)

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) FIGURE 8.10 The S = I Approach to Equilibrium

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 38 EQUILIBRIUM AGGREGATE OUTPUT (INCOME) ADJUSTMENT TO EQUILIBRIUM  The adjustment process will continue as long as output (income) is below planned aggregate expenditure.  If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to equilibrium, with Y higher than before.  If planned spending is less than output, there will be unplanned increases in inventories.  In this case, firms will respond by reducing output.  As output falls, income falls, consumption falls, and so forth, until equilibrium is restored, with Y lower than before.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 38 THE MULTIPLIER multiplier The ratio of the change in the equilibrium level of output to a change in some autonomous variable. autonomous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. This added income does not vanish (dissapear) into thin air. It is paid to households that spend some of it and save the rest. The added production leads to added income, which leads to added consumption spending.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 38 THE MULTIPLIER FIGURE 8.11 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 38 THE MULTIPLIER THE MULTIPLIER EQUATION Because  S must be equal to  I for equilibrium to be restored, we can substitute  I for  S and solve: therefore,, or The marginal propensity to save may be expressed as: Equilibrium will be restored only when saving has increased by exactly the amount of the initial increase in I.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 38 THE MULTIPLIER THE SIZE OF THE MULTIPLIER IN THE REAL WORLD In reality, the size of the multiplier is about 1.4 That is, a sustained increase in autonomous spending of $10 billion into the U.S. economy can be expected to raise real GDP over time by about $14 billion.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 38 actual investment aggregate income aggregate output aggregate output (income) (Y) autonomous variable change in inventory consumption function desired, or planned, investment equilibrium identity investment REVIEW TERMS AND CONCEPTS marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier paradox of thrift planned aggregate expenditure (AE) saving (S) 1. S ≡ Y − C MPC + MPS ≡ 1 4. AE ≡ C + I 5. Equilibrium condition: Y = AE or Y = C + I 6. Saving/investment approach to equilibrium: S = I 7.

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 38 DERIVING THE MULTIPLIER ALGEBRAICALLY Appendix Recall that our consumption function is: C = a + bY where b is the marginal propensity to consume. In equilibrium: Y = C + I Now we solve these two equations for Y in terms of I. By substituting the first equation into the second, we get:

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 38 DERIVING THE MULTIPLIER ALGEBRAICALLY Appendix This equation can be rearranged to yield: Y − bY = a + I Y(1 − b) = a + I We can then solve for Y in terms of I by dividing through by (1 − b):

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 38 DERIVING THE MULTIPLIER ALGEBRAICALLY Appendix Now look carefully at this expression and think about increasing I by some amount, Δ I, with a held constant. If I increases by Δ I, income will increase by Because b ≡ MPC, the expression becomes

CHAPTER 21: Aggregate Expenditure and Equilibrium Output © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 38 DERIVING THE MULTIPLIER ALGEBRAICALLY Appendix The multiplier is Finally, because MPS + MPC ≡ 1, MPS is equal to 1 − MPC, making the alternative expression for the multiplier 1/MPS, just as we saw in this chapter.